38 • • Securities Market Regulation in Canada • • The Fraser Institute
with any information about the quality of an exchange’s self-regulation.
The approach becomes more effective at foster-ing fair and efficient markets if foreign marketplaces are not discriminated against because this would maximize the potential benefits from competition. This approach is consistent with trends in other regulated financial sec-tors, such as banking, where regulators are increasingly emphasizing the benefits of transparency, disclosure, and market discipline in achieving public objectives. If the CSA members involved in oversight adopt common rules for the performance review requirement, they would effectively eliminate the burden of multiple regulation for exchanges.
A transparency approach is a logical step forward, not just for Canadian regulators struggling with what is widely recognized as a costly and inefficient system, but for all jurisdictions with well-developed capital markets that recognize the benefits of globalization. If several countries adopt a transparency approach, it will ease regulatory barriers to cross-border entry so that market places will not be subject to multiple regulatory regimes when operating in more than one jurisdiction.
A transparency approach would also facilitate the emer-gence of global stock markets that some marketplaces, such as NASDAQ, have already publicly stated as their strategic objective. Consideration could be given to a high level international set of standards that could be used for market access decisions to cover institutional foundations, such as legal regimes and settlement system infrastructures.
Consideration would also need to be given to competition policy for the review of mergers and acquisitions.
One possible criticism of this approach is the free rider issue. A trading place could conceivably establish itself as a marketplace that undercuts competitors that devote more resources to regulating its issuers. The likely market outcome for addressing this issue, if this issue does materialize, would presumably be in pricing structures that provide a high-end market self-regulator the incentive to continue to fulfill that role.
Distribution
SROs
In the case of the IDA and MFDA, completely replacing the current regulatory oversight regimes with a transpar-ency approach may not yet viable. As noted earlier, as self-regulators, these organizations are essentially monopolies and do not have the same private incen-tives as competing SROs to use quality regulation as a competitive advantage for their members. In
addition, there are incentives for the SROs, as non-profit organizations, to act in the interest of members rather than dispersed, profit-seeking shareholders.
However, the transparency approach can greatly reduce the need for the micro-oversight that SRAs are increasingly engaging in, and steps can be taken to promote some competition to reduce even more the need for this oversight. This approach could also contribute towards building stronger public confidence in SROs responsible for financial product advice and distribution.
A first step towards fostering regulatory competi-tion would be for the CSA to reconsider its nacompeti-tional policy on cross-border activity in order to facilitate some competition from members of foreign SROs.
CSA members have chosen the strictest conditions, outlined by IOSCO in its first Internet paper, for not exercising regulatory authority over cross-border securities activities by an intermediary located in another jurisdiction, including requiring intermediaries to take steps to prevent sales to residents of a CSA jurisdiction.
For intermediaries outside their jurisdiction, Canadian SRAs could choose to decline to exercise regulatory authority, as long as the intermediary does not deliberately target residents in that jurisdiction.
This policy was discussed in the BCSC Paper, New Concepts for Securities Regulation. It is consistent with IOSCO’s recommendations and would introduce limited competition for Canadian SROs that are essentially regulatory monopolies. This policy would also benefit Canadian investors, by allowing them access to foreign providers that might be more competitive in price or service. SRAs could consider applying this policy to all jurisdictions or only to jurisdictions that have adequate institutional underpinnings, such as robust legal regimes and reliable settlement systems.
The benefits of competition would further increase if Canadian SRAs pursue “passport” agreements with other jurisdictions. Under the EU’s Investment Services Directive, investment firms other than banks are allowed to operate anywhere in the Community, once they have obtained authorization in their home member state (the single passport system). Passport arrangements with other jurisdictions would result in the establishment of competing SROs in Canada, thus paving the way for the transparency approach to fully replace regulatory oversight regimes.
Registration
The other key element of intermediaries regulation by SRAs is the registration function. In the past, a case may have existed for each Canadian jurisdiction to require
The Fraser Institute • • Securities Market Regulation in Canada • • 39
registration of intermediaries already registered in other Canadian jurisdictions. This requirement could be justified by practices such as setting up in one province a boiler-room for telephone sales of questionable securities to investors in a different province to avoid the local authorities. These justifications no longer exist, given the extent of the level of co-operation between SRAs that now exists.
CSA members are introducing a National Registra-tion Database (NRD) through which firms and individuals can submit registration applications to SRAs and SROs.
Despite the cost savings that NRD might generate, the absurdities of multiple registrations within Canada remain. This system is also a huge barrier to pursuing passport agreements with other jurisdictions that could unlock the public benefits of competition for SROs.
One solution is for SRAs to withdraw from the registration function altogether, leaving it in the hands of SROs that operate nationally across Canada.
Implementing the transparency approach to reduce the need for oversight would help facilitate the SRAs’
departure from direct involvement in the registration function, through its contribution to public confidence in SROs. SRAs would still be able to restrict intermediar-ies directly, but only through disciplinary measures undertaken as part of enforcement activities. Other possible solutions include a national securities authority that would be responsible for registration and using the EU’s “passport system” within Canada.31
Issuers
The Governance-Gap Approach
Some SRAs have publicly stated the objective of pursuing a “compliance culture” for corporate disclosure by issuers.
An alternative approach that reflects the secondary relevance of SRAs for quality corporate disclosure could be called the “governance-gap” approach. This approach recognizes that governance is the best tool (rather than regulation) to ensuring that issuers make the best decisions, in their shareholders’ interests, regarding information disclosure. Since perfect governance is a theoretical notion and governance quality varies in practice, this approach would promote quality govern-ance but rely on civil remedies and, to a lesser extent, regulation to address governance shortfalls.
The problem with promoting a culture of compli-ance is that issuers will increasingly focus on complicompli-ance (i.e. follow the rules in their smallest detail) as opposed to setting the best possible disclosure as an objective.
Earlier in the paper, it was noted that disclosure and governance reinforce each other. This reinforcement leads to the notion of a governance-disclosure virtuous
circle, whereby improved disclosure contributes to good governance and good governance leads to improved disclosure.
Aggressively encouraging a compliance culture with mandated disclosure requirements throws a monkey wrench into the virtuous cycle, while ideally a regulatory framework should be structured to foster the cycle. Thus, a governance-gap approach would include some of the recommendations of the Saucier Final Report, such as developing a program to support and encourage ongoing research, analysis, and education in corporate governance. Indeed, better measurements of governance quality need to be developed.
The Gompers, Ishii, and Metrick paper offers some insight on measuring governance quality. Rather than take into account how the board was structured (i.e. the number of independent board members on the audit committee and whether the CEO is separate from the Chair), the authors measured governance quality by examining the balance of power between management and shareholders. For example, if a firm adopts a poison pill, this will count against the firm in the measurement of its governance quality. This appears to be a sound approach for defining and measuring corporate governance, given the linkage to shareholder value the study found.
Introducing new regulations to improve govern-ance offer limited benefits. McKinsey’s review of corporate governance practices concluded that initia-tives in this vein have been ignored or applied in the spirit of technical compliance with the law (McKinsey 2001). The study suggests that reformers need to pay more attention to institutional reforms (i.e. the underlying structure of property rights).
As noted earlier in this paper, SRAs have been expanding mandated disclosure requirements and increasing the resources allocated to the review of continuous disclosure filings. Under the governance-gap approach, SRAs would rely more on governance and civil liability as the first and second lines of defense against inadequate disclosure, rather than expanding the role of regulatory supervision and continuing to add to mandated disclosure requirements. While some SRA review may be useful in determining trends and identifying new issues, taking direct responsibility for the quality of the minutiae in the continuous disclosure of all issuers is a potential bottomless pit for regulatory resources. Either massive staff increases for the commissions would be required, creating unsustainable regulatory costs, or a sub-standard job would be done because of corner-cutting. A more realistic continuous disclosure role for SRAs is war-ranted—one that can be clearly articulated to investors and that is achievable cost effectively.
40 • • Securities Market Regulation in Canada • • The Fraser Institute
Despite the reputational damage to the auditing profession from the Enron collapse, public auditors, rather than SRAs, should be relied on to ensure the integrity of financial statements. In Enron’s case, the SEC32 had a role in ensuring the integrity of financial statements, which were also the responsibility of Enron’s management, board, and auditor. The auditing firm is being sued and has been criminally indicted, while it appears likely that the SEC will get a significant budget increase. Clearly auditors have stronger incentives to do a good job.33
Under the governance-gap approach, SRAs would scale back on their disclosure requirements to provide exchanges with the opportunity to set both disclosure and governance standards as they see fit. Having both disclosure and governance rules set at the exchange level is preferable because it allows exchanges to set a mix of these rules to differentiate themselves from their competitors. It also allows exchanges to tailor their rules to their target niches. For example, an exchange designed for junior issuers might choose to set higher requirements for disclosure and less prescriptive requirements for governance than an exchange focused on large companies.
Finally, the governance-gap approach would incorporate a civil remedy regime for continuous disclosure filings as recommended by the Allen Com-mittee on Corporate Disclosure, which the CSA has moved forward, but which has yet to be adopted in any jurisdiction in Canada.34 By facilitating private enforcement, a civil remedy regime would serve as the first line of defense against governance failures. The case for private enforcement in general is outlined in a paper by Trebilcock and Roach: “The private enforcement of public laws can act as a check on the monopoly power of enforcement that would otherwise enjoy. A private individual who has suffered a violation may be in a better position and may have better information to enforce public laws than a public official. It is the aggrieved person rather that the public official who has the greatest incentive to seek corrective justice in the form of damages or other remedies.”35
The case for private enforcement in investor protection was recently strengthened by the Supreme Court of Canada ruling on Cooper v. Hobart. In 1997, the BC Registrar of Mortgage Brokers, a statutory regulator, suspended a mortgage broker and froze its assets because the broker was allegedly using the funds for unauthorized purposes. A suit was brought forward against the registrar by an investor who alleged that losses would have been avoided had the broker been closed down sooner.
The Supreme Court upheld a decision in favour of the defendant. It ruled that although, to some degree,
the provisions of the Mortgage Brokers Act serve to protect the interests of investors, the overall scheme of the Act mandates that the Registrar’s duty of care is not owed to investors exclusively, but to the public as a whole. Thus, it could be argued that aggrieved investors clearly have stronger incentives to seek remedy in the form of damages.
One drawback of civil liability is that it can lead to a “liability culture.” Similar to a “compliance culture,”
in a liability culture, disclosure is structured primarily around avoiding liability rather than informing investors.
Governance clearly needs to be the first line of defense.
A second drawback is that increasing director liability can discourage competent and qualified people from becoming directors (Saucier 2001).36
In the governance-gap approach, the role of SRAs would primarily be to complement private enforce-ment by taking public enforceenforce-ment action against deliberate disclosure of misleading information and other contraventions of securities legislation. Depending on the extent to which a new civil remedy regime facilitates class action, there might also be a role for SRAs to take enforcement actions in situations where there is inadequate incentives to sue by any individual investor. There may also be a beneficial role to play in regulating mandated disclosure for issuers on local exchanges or unlisted securities.
Multiple SRAs
As noted earlier, it is well recognized, including by some of the SRAs themselves, that the Canadian regulatory system is costly and inefficient. Issuers who choose to offer securities across Canada face the regulatory requirements of all thirteen jurisdictions. This may in fact be part of the reason for the significant decline in foreign-based issuers choosing to inter-list in Canada.
Without question, a model along the criteria set out at the beginning of this section would stipulate that any given issuer in Canada should not have to face more than one regulatory regime. There are two ways this could be achieved.
The first option is to move the regulation of issuers to a national level. This would be the most logical choice, if CSA members proceed with adopting the same statute. A common statute negates any conceivable benefit that could flow from having multiple regulators unless the statute is eroded through non-statutory instruments in which case a system of inconsistent regulatory regimes continues to persist. National regulation is attractive in terms of simplicity, may generate scale economies, and may be helpful in building international agreements on market access. However, to the extent that a national regulator is effectively a
The Fraser Institute • • Securities Market Regulation in Canada • • 41
monopoly, its incentives to stay responsive to the needs of market participants are weaker. Another drawback is that a “one size fits all” approach may not produce a regulatory system suitable to meet the needs of both large seasoned issuers and junior companies.
The other option is to leave issuer regulation to provincial commissions, but under a system in which an issuer can choose which commission it wants as a regulator and can offer securities across Canada based on the authorization of that one regulator.37 This option extends a concept outlined by Mr. Brown in his speech calling for a pan-Canadian regulator, in which he indicated that SRAs were exploring legislative changes that would allow them to delegate authority to make specified decisions.
The advantage of this option is that it creates competition among SRAs.38 A study by Roberta Romano concludes that state competition in the US has produced innovative corporation codes that quickly respond to changing market conditions and firm demands (Romano 1993). Competition for incorporation revenues makes US states sensitive to investor concerns, and empirical studies have shown that investors benefit from state competitive behavior (Romano 1993).39 In a subsequent paper, Romano makes the case that extending competi-tion into the produccompeti-tion of securities laws would be desirable because promoters of firms would be able to lower their cost of capital by choosing the regime that investors prefer (Romano 1998). Through registration
fees, states have the financial incentives to adopt securi-ties regimes to attract companies to their jurisdiction (Romano 1998).
Competition among different jurisdictions could lead to more dynamic regulation than under a national regulator. In addition to discouraging SRAs from burdening market participants with unnecessary or poor quality regulation, another benefit is the financial discipline that would be imposed on the commissions, as fees would be a consideration for issuers in choosing an SRA.40 The monopolist disadvantages associated with national regulation could, however be minimalized through fostering more regulatory competition from SRAs in foreign jurisdictions.
The competition approach would address the concerns of some provincial regulators that national regulation would not be suitable for junior markets, as one or more commissions could specialize in this area.
A regulatory response to slumping junior markets in 2001 provides a good illustration of this point. The ASC and BCSC chose to respond to these market conditions by easing the public offering requirements for CDNX listed companies.41
One drawback of this model is the lack of a national voice for representation in organizations like IOSCO and other international discussions. Another is that experience in the EU shows this type of arrangement is more difficult to implement in practice than the theory suggests.
42 The previous section covered only a few major ele-ments of securities regulation, rather than offer a comprehensive model for securities regulation. The objective was to present a methodology by which SRAs, currently reviewing regulatory requirements with an intent to improve regulation and ease the regulatory burden, can take advantage of market forces. In this methodology, the regulatory roles of SRAs are broken up into various pieces, and the need for each piece is evaluated against existing private incentives that can be tapped into to achieve public policy goals.
By and large, it appears that Canadian investors and companies, relying on markets for funding, could be better served with a regulatory model constructed on this premise. Some other conclusions that can be drawn from this review of the Canadian regulatory landscape and industry structure are outlined below.
1) Despite signs of increasing obsolescence, Canadian SRAs have significantly tightened practically every aspect of the regulatory environment, and some commissions are keen to tighten things further. The growing levels of supervision of SROs and market participants show that the recent build-up of staff levels by some of the commissions cannot be attributed merely to rising levels of market activity.
2) Given the extent of the financial and policy independ-ence of commissions that converted to Crown Corporations, provincial authorities should give strong consideration to defining appropriate account-ability measures. Prior to the conversion to crown
2) Given the extent of the financial and policy independ-ence of commissions that converted to Crown Corporations, provincial authorities should give strong consideration to defining appropriate account-ability measures. Prior to the conversion to crown